Contemplating Italian debt restructuring

This week’s evaporation of confidence in the euro zone’s biggest government debt market — Italy’s 1.6 trillion euros of bonds and bills and the world’s third biggest — has opened a Pandora’s Box that may now force investors to consider the possibility of a mega sovereign debt default or writedown and, or maybe as a result of, a euro zone collapse.

Given the dynamics and politics of the euro zone, this is a chicken-or-egg situation where it’s not clear which would necessarily come first. Greece has already shown it’s possible for a “voluntary” creditor writedown of the country’s debts to the tune of 50 percent without — immediately at least — a euro exit. On the other hand, leaving the euro and absorbing a maxi devaluation of a newly-minted domestic currency would instantly render most country’s euro-denominated debts unpayable in full.

But if a mega government default is now a realistic risk, the numbers on the “ifs” and “buts” are being being crunched.

In that light, Mark Schofield and Jamie Searle, strategists at U.S. investment bank Citi, on Thursday attempted to figure out “fair value” for Italian government borrowing rates in the light of the week’s dramatic events that saw 10-year yields on the bonds briefly top the “make-or-break level of 7% . Their conclusion was that Italian debt crunch was likely to get get a lot worse before it got better, absent a “significant and sizeable” political intervention. By this, they are referring to the only scenario that they see would trigger a near-term turnaround — open-ended ECB buying on a scale far greater than currently being seen. However, they reckoned they still seems unlikely, for now.

What’s left of the 440 bilion euro bailout fund is not big enough to rescue Italy — where more than 300 billion euros needs to be found next year alone to pay interest costs and replace maturing debt. And with the recently-agreed, leveraged-up version of that EFSF unlikely to be finalised until next monthat the earliest, the Italian market is left in limbo.

As a result, the Citi analysts say it’s become impossible to assess fair value for the market based on macro fundamentals such as debt stock, budget deficits, national growth, inflation and central bank interest rates. So, they reckon they have to apply a “recovery-based default model” that takes in hypothetical debt restructurings and default probabilities. Given the recent Greek example, the 50% debt haircut has inevitably become a reference point.

Given that scenario, they reckoned 10-year Italian borrowing rates would have to rise as high as 14.5% — more than twice current rates — to compensate for the risks.

With the supply/demand equilibrium as the only determinant of market levels, BTPs have found themselves in the vacuum that a recovery based framework using our Fiscal Risk index suggests should exist between 6% and 9%. Post any restructuring we could theoretically see 10yr yields fall back to about 4.75% but of course the corollary to this is that it may entail a haircut. To breakeven at 4.75% after a 50% haircut for a 10yr bond investor would need yields in excess of 14.5%.